The world of valuing financial assets more importantly stocks and shares have undergone a dramatic change in the last 10 years, some changes attributable to innovations & evolutions in methods of valuation more particularly a new paradigm of valuing new age/online technology-led businesses. One sector which hasn’t surprisingly been impacted by changes in valuations is the commodity sector mainly steel, aluminium, cement, etc. This topic will deal essentially with the steel sector, which I am associated with for the last 23 years.

The steel sector in India and China, two large hubs of steel manufacturing were widely held between primary & secondary steel manufacturers. In long products Industry was characterised both by small & crude manufacturing and companies with fairly large capacities with better & refined steel faculties,  former catering to predominantly construction & infra needs of lower strata of retail markets and latter to large construction projects .  Off course flat steel manufacturing was always the forte of bigger players as this steel required better technology, scale, and quality.

At the beginning of the century, the Indian and China steel industry was in the development stage transiting from a medium to a large size. When such transition happens in any industry, it creates bigger players and consolidation through the annihilation of smaller ones. This stimulates competitiveness, efficiency, better technology, integration of operations, and professionalism more proactively. . Led by a global commodity boom from 2003 onwards, the global steel industry propelled in demand & size. The staggering expansion of Chinese steel capacity to over 800 million tonnes created a new balance of global steel outlook dominated by Chinese demand and supply. Incremental Steel & other commodities manufacturing however stabilized after financial crises but the overhang of excess capacities globally continued to be a challenge for the industry. After a stable period from 2009-2014, the industry went through a rough patch from 2014 to 2018  putting a halt on Greenfield expansions and brownfield capacity initiatives. This period saw large-scale stress and consequent consolidation in India fast-tracked by much debatable IBC. Smiler consolidation and contraction were seen in China and other parts of the globe. Unintegrated & crude capacities ruthlessly created in past all over either saw closure or consolidation. . Chinese authorities ordered the closure of higher polluting and low viability steel capacities and it triggered consolidation of smaller players in China.

What has now emerged is relatively a better organized, improved technology-backed,  reformed, and largely integrated capacity in the steel hub of China and India. The steel industry in Japan and US was always well-structured and had seen expansions like China followed by India before 2010 but such expansion was in moderation.

Valuation of steel companies in the context of key Indian companies

India has seen a massive consolidation after the introduction of IBC, much to the advantage of large players and selective injustice to some of the well-known steel companies. Today Indian industry is dominated by JSW, TATA Steel, Sail, JSPL, and Arcellor Mittal, together with controlling 60% of the market share. All of these companies have integrated & value-added product streams with dominant market share. Debt levels of all the companies are at comfortable levels of coverage to their operating profits, management competence levels are high, the companies are supervised by high-quality boards & corporate governance is compliant with regulatory and market norms. The biggest distinct feature of all these companies is the entry barrier next to impossible to challenge their business.

One million ton steel capacity will require about 5000 crores to set up and brown field expansion may cost marginally lesser to scale up the capacity. On a uniform basis capital investment of following sample companies has been assumed at 5000 crores per mn. ton . Actual asset base as per published results vary but would be higher than assumed .

Company	Capacity	Replacement Period	Capital Investment (Approximately)
TATA Steel	33mn	20	1,65,000
JSW	27mn	18	1,35,000
JSPL	10mn	12	50,000
SAIL	21mn	15	1,05,000

Note, capacity has been assumed based on information available in the public domain, and media announcements include capacities at the advanced stage of construction.

Besides, Replacement Cost, the number of years to create the above capacities would range from 12 to 20 years for a capacity of 10mln to 30mln tons as the same involves the massive acquisition of land,  various approvals, tie-up of funds, and implementation of project, etc. The experience of setting up large capacities of steel in India by some new foreign players in the past is not suggestive of any successful history,  demonstrating a tough entry barrier for new players to create large capacities.

The above data suggests that these companies have become mammoth by their scale & size. The above factors in themselves have become huge entry barriers to large projects in India. Entry barrier in itself creates a big premium to existing assets capable of generating strong cash flows. Steel industry which was widely held, essentially non-integrated in operations, not efficient in the value chain, competing for space in the market, and last but not the least balance sheets laden with heavy debt and all of that has changed now. Significant reduction in greenfield projects and selective green field expansion and consolidation in the last few years, increased focus on integration in operations particularly in first & 2nd rung steel companies, visible market space, and massive debt reduction has resulted in a stronger industry. 

Thus the enterprise value of these companies ought to represent EBITDA levels for the replacement period at a discounted level to provide for volatility and even without considering any growth. This is the minimum value attributable to these companies.

The following table reflects the enterprise value these sample companies ought to be given as against where they stand valued by markets .Other  companies in the industry with partial to full integration in operations & strong balance sheets deserve the similar valuation.

(Rs in crs )

Company	TATA Steel	JSW	JSPL	SAIL
Current EBITDA	62,390	45,888	18,292	26,720
Replacement Period EBITDA	12,47,800	8,25,984	2,19,504	4,00,800
Discounted EBITDA	9,35,850	6,19,488	1,64,628	3,00,600
Current Debt	81,901	61,730	21,551	35,576
Resultant Enterprise Value	10,17,751	6,81,218	1,86,179	3,36,176
Current EV	2,54,067	2,17,575	61,918	85,142
Current Ev/ebitda	3.90	4.74	3.38	3.18
Valuation Gap	7,63,684	4,63,643	1,24,261	2,51,034
RevisedEv/ebitda	16	15	11	13
Ideal Market cap	6,81,783	4,01,913	1,02,710	2,15,458
Current Market cap	1,59,000	1,55,845	42,500	49,600
Undervaluation Of equity	5,22,783	2,46,068	60,210	1,65,858

1. EBITDA represents annualised EBITDA of declared results of Q1
2. Debt levels have been taken based on audited results of 31 march,21 in respect of published results & from sources not in public domain
3. Capacity is taken based on declared results & near-term proposed completion of capacities and  may vary with the actuals  marginally with little bearing on the outcome.
4. Valuation of tata steel captures the profitability of captioned capacity & in the case of JSW steel the valuation is captured only to the extent of operational capacity app 22millions tonnes. Similarly capacity od SAIL & JSPL is based on available data in public domain.
5. Replacement cost has been assumed on a standardised basis per million tons of steel, the actual cost could vary depending on capitalization over some time since the inception of companies. capital cost however has gone up due to higher prices of commodities & other inputs .

The above table explains the rationale for arriving at the real value of the above sample Companies. The discount factor of 25% has been taken to guard off of cyclicality of the nature of the steel business. Besides, no growth is assumed in profits in the projected period. The real equity value represented by the market cap as per the above table ought to be the actual value of equity given to the steel companies. This will translate into higher EV/EBITDA and price earning multiples which will reflect the fair value of these and other companies in the sector.

Take the case of TATA Steel which has a capacity of 33mln tonnes, it will take at least 20 years to put a steel mill of its size from land acquisition, approvals, fund tie-up, project execution, etc given my experience of green field project implementation if at all it is assumed that the project of this scale and size will get completed. During the same period, Tata will make a gross EBITDA of Rs 12.47 lac crores. Assuming an average discount factor of as high as 25% without any growth from year on year if one has to buy Tata steel instead of putting up the project, it will command a value equivalent to the discounted value of Rs. 10.17 lac crores. The current Enterprise Value is Rs 2.54 lac crores. Hence there is a clear gap of Rs 7.63 lac crores to the deserved value of Tata Steel.

The simple argument is why would one value these companies on an EV/EBITDA norm as illustrated above in deviation to a visible period of 4 to 6 years generally followed in the valuation model. The answer is this model of EV/EBITDA has lost relevance in the context of tough entry barriers led by long gestation periods and heavy capital investment, strong revenue & profitability stream.

At these valuations, PE multiples would expand from the current range of 5 to 7 times to 14 to 20 times  which sound logical, rational, and justified by at least the profitability visibility and balance sheet strength. 

 Contrary to above model calculation ,even if we assume present value of ebitda earnings for replacement period , the enterprise values will still remain higher than what the market is offering .

COMPANY	NPV@8% Ebitda	DEBT	EQUITY VAL	CURRENT  MARKET CAP.	UNDERVALUATION
TATA STEEL	6,12,554	81,901	5,30,653	1,59,000	3,71,653
JSW STEEL	4,11,263	51,730	3,59,533	1,64,000	1,95,533
JSPL	1,37,850	21,551	1,16,299	42500	73,799
SAIL	2,28,709	35,576	1,93,133	49,600	1,43,533

Both the above calculations of equity value manifest a steep discount in market cap of above sample companies .It belies any explanation of market caps which do not reflect a fair & justifiable value of equity  purely on fundamentals and accepted financial matrix of these companies.

Besides, what’s the essence of value. The value in simple terms is the price any product or service will fetch in the market. Can we expect the promoter of a steel company making an annualised EBITDA of 15 thousand crores with a strong potential of growth to sell the company at a value of 50 to 60 thousand crores at EV/EBITDA of 3.5 to 4.5, where most of the fully integrated & profit-making companies are trading or a company making 30 to 40 thousand crores of EBITDA being sold at 1.25 to 1.50 lakh crores at an EV/EBITDA of 3-4 times.? No controlling shareholder is going to sell the controlling stake at these ridiculous valuations. We will never see a company  with a robust business model getting sold at these pathetic valuations. Apart from valuations based on profitability, there is a huge premium on controlling stake in India. The premium of the controlling stake should ideally be embedded in the market cap given its strong influence on price. The premium of controlling stake however has been ignored in the above calculations.

The argument could be why would the matrix of valuation as per the above table be accepted but the counterargument is why would valuations representing PE multiples of 30 to 70 times be accepted for other industries like FMCG, AUTO, etc.

The next argument is relative valuations of sectors where steel is the main input. Let’s take the auto sector. Auto sector profitability is directly linked to steel the main input cost. Demand & supply in the Auto sector may be important which is paramount in any sector but profitably has a direct bearing on steel costs. Further auto sector is vulnerable to demand but more to an unending supply of new models changed technologies, ever-evolving customer preferences however sector has equally tough entry barriers on account of brand building, heavy capital investment et al yet the sector has received decent valuations far superior to the steel sector. Some of the vibrant examples are as under – 

(Rs. In Crore)

Company	EBITDA As on 31.03.2021	Market Capitalisation	EV/EBITDA
M&M	4,064	97,118	30.07
Maruti Suzuki	8,291	2,24,344	29.31
Eicher Motors	2,249	73,970	34.20
Tata Motors	3,728	1,03,228	40.03
Ashok Leyland	643	37,267	75.85

Similarly FMCG sector, the sector is seeing the entry of new players in niche products & geographic areas offering reasonable quality at economical costs, consolidation, and stiff competition from e-commerce companies, of course, e-commerce companies don’t sell their products but sell the products of the same companies but it has challenged well-oiled distribution channels of well-established companies to the advantage of companies with weaker distribution networks. E-commerce has created disruptions in the demand-supply patterns of FMCG companies yet the valuations of these companies remain unaffected & have rather improved over time as per the following table of sample companies.

(Rs. In Crore)

Company	EBITDA As on 31.03.2021	Market Capitalisation	EV/EBITDA
HUL	11,610	5,72,214	51.07
P&G Health	277	9,508	59.65
Dabur	1,836	1,04,128	57.87
Marico	1,440	68,603	48.65
Colgate Palmolive	1,540	46,973	41.72

Historical reasons for valuing steel companies at a lower multiple compared to other industry players are driven by the cyclical nature of business and heavy capital investments and debt in the balance sheet. Equity funding of scale required to fund steel companies was not available from the market nor did the promoters possess deep pockets to invest the equity needed, hence all steel companies & all commodity companies would carry heavy debt in the balance sheets which magnified the risk of the business, hence attracted low equity premium from investors.

That has all changed, the Steel Company’s balance sheets are stronger today with low debt, large capacities, and robust operating cash flows. Dependence of Debt for sustaining operations has significantly come down and even expansions are driven essentially by internal generations of cash. Option of debt is scarcely exercised.

To summarise the low valuation of steel companies have the following underlying reasons;

1.   Cyclical

2.   Heavy capital outlays

3.   Debt driven balance sheets

4.   Steel and commodity businesses are driven by international demand and supply with relative influence by conditions.

The cyclical nature of steel might continue but the challenge post by the down cycles is countered in terms of managing their cost-effective integrated operations and strong balance sheets.

The heavy capital investment is preferred now only by established steel players which anyways require lower levels of capital outlays for expansions mainly funded by internal generations. Debt is no longer preferred as a primary source of funding and the managements have become extremely careful in loading the balance sheets with the debt given the sword of defaults and consequent outcomes on account of IBCs and other regulations.

According to the changed paradigm, the steel industry operates today, and considering the stiff entry barrier owing to heavy capital investment, a very long project gestation, the valuation of steel companies based on age-old principles treating it as a commodity is far from justified.

Valuations need to be more objective, aligned to the fundamentals of business considered important to “value”.

The above factors indicate a legacy bias in valuations of different sectors. It’s difficult to argue why  the bias persists given conceptual change in valuations dictated by new-age companies. It looks highly probable that this anomaly of low valuations of steel companies will get corrected as the sector will see the emergence of bigger and bigger players, with unmatched capacities, robust business models, predictable cash flows, and last but not the least well capitalised Balance sheets, backed by high-quality management and power-packed Boards. 

The guidance to valuations of these companies as illustrated in preceding paras will eventually have acceptance.

Valuations in equity markets have become highly subjective than objective. Subjective valuations don’t reflect an alignment of values across sectors representing the real fundamentals and risks. Valuations of new-age tech companies have challenged the conventional and established models of valuations and are highly subjective in assumptions and numbers.

There are no tangible arguments of assigning higher valuations to negative cash flow tech companies, steep price earning multiples to FMCGs, and ultra-conservative multiples to companies with solid asset base and strong positive cash flows … unambiguously  steel sector looks a big victim

Disclosure: The article has been written in my personal capacity and does not relate or reflect the views & opinions of management of the company , I am currently or in past associated.

The article is not intended a research report on the companies covered but could be of academic interest.